French Finance Minister Pierre Moscovici, left, and Olli Rehn, the European Union's economics commissioner, say the euro zone's bailout fund should be allowed to help ailing banks. (Sebastien Pirlet/Reuters)

French Finance Minister Pierre Moscovici, left, and Olli Rehn, the European Union's economics commissioner, say the euro zone's bailout fund should be allowed to help ailing banks.(Sebastien Pirlet/Reuters)

Bank bailouts are rolling, as the banking crisis displaces the debt crisis as the euro zone’s top threat.

On Monday, shortly after Cyprus, the zone’s third-smallest economy, said it might seek a banking sector bailout, the Portuguese government announced it will inject €6.6-billion ($8.6-billion) into the country’s three largest banks. Most of the money will come from the sovereign bailout arranged last year by the European Union and the International Monetary Fund.

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The Portuguese bank bailout comes as Spain struggles to contain its own banking crisis after last week’s failed attempt to shore up Bankia, the fusion of seven ailing lenders that is in need of €19-billion in fresh capital.

Fears that Spain’s banks are on the verge of disaster have sent Spanish bond yields soaring to 6.5 per cent, only slightly below the 7-per-cent level that triggered the bailouts of Greece, Ireland and Portugal in 2010 and 2011.

The deepening banking crisis on the euro zone’s Mediterranean frontier has European Union and national finance ministers scrambling for a solution, for fear that a run on the banks will plunge Greece, Spain, Portugal and Italy into financial chaos, destabilizing the entire region.

On Monday, Olli Rehn, the EU’s economics commissioner, and Pierre Moscovici, France’s new finance minister, said the European Stability Mechanism, the permanent bailout fund that launches next month, should be allowed to pump capital directly into ailing banks.

Currently, the ESM can lend only to governments, which in turn lend to banks.

“I want to underline that we have been considering this as a serious possibility for breaking the line between sovereigns and the banks,” Mr. Rehn said, adding that the idea is part of a broader discussion about possible ways “to create a banking union.”

Germany has resisted deploying the ESM to recapitalize banks, because it worries that the loans might be offered without the strict conditions that come with sovereign bailouts.

Supporters of direct-to-bank ESM loans, including France, Italy and Spain, argue that ESM injections would be faster and more efficient, since time is of the essence when a bank begins to unravel. They also note that direct loans mean the country itself would not be taking on extra debt that would raise its debt payments and jeopardize its credit ratings.

The notion of a banking union is gaining momentum and is expected to come up for discussion at a special Group of Seven finance ministers conference call on Tuesday, and again at the June 28-29 EU summit.

“The real concern right now is Europe, of course, the weakness in some of the banks in Europe, the fact they’re undercapitalized, the fact the other European countries have not taken sufficient action yet to address those issues of undercapitalization of banks and building an adequate firewall,” Canadian Finance Minister Jim Flaherty told reporters Monday in Toronto.

No definition of a banking union yet exists, except in the broadest terms. Various reports suggest it would include euro zone-wide deposit insurance (as opposed to insurance at the national level), a recapitalization fund, and a central banking regulator.

But Germany is bound to resist a full banking union if it were to include collective deposit insurance, just as it has rejected the launch of euro bonds, which would pool the debt of the 17 euro-zone members, bringing down the financing cost of the weakest.

Writing in Financial Times Deutschland, Georg Fahrenschon, head of Germany’s association of savings banks, said he would fight the launch of joint deposit insurance, noting that German deposit insurance is financed from the profits of German savers’ deposits.

“If these funds are used to cover deposits at foreign banks, they will no longer be available for our member institutions,” he wrote. “German customers would have to use funds to support foreign banks.”

While many economists think joint deposit insurance would help prevent a run on the banks in weakest countries, some think such a plan would be politically or legally impossible.

“Even if the German government were willing to sign Germany up to backstopping bank deposits in the southern European countries, the German Constitutional Court would find it illegal on the basis that Germany’s financial exposure would be unlimited in nature,” Megan Greene, director of European economics at Roubini Global Economics, said in a note.

Cypriot President Demetris Christofias told a news conference last Friday that he could not rule out a bank bailout. “I don’t take it as a given that we will negotiate entry into a support mechanism [but] I don’t want to absolutely exclude it,” he said.

The country’s second-largest lender, Cyprus Popular, faces nationalization if it does not find new investors by mid-year. It needs €1.8-billion to meet its tier 1 capital requirements, equivalent to 10 per cent of gross domestic product. Other Cypriot banks might get into trouble too, because together they have €23-billion of exposure to Greece.

How much Spain might need to prop up its banks is an open question. Analysts at UBS have estimated that the Spanish banking system might need as much as €120-billion of fresh capital.

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